The low volatility equity opportunity

Low volatility equity investing has gained increasing attention within the investment community over the last few years.

Against a backdrop of the Sovereign Debt crises and uncertainity about the macroeconomic uncertainty, investors are finding that these strategies provide a timely opportunity to address both return and risk priorities. We think the most important equity risk priority is reducing the chance of losing capital and this is the basis for a low volatility portfolio. Put another way, by reducing ‘risk’ we are seeking to smooth out some of the high and lows of the rollercoaster ride that can be equity investing. For low volatility investors, absolute return measures of risk have supplanted benchmark aware risk measures, such as tracking error or information ratio, which contain inherent risks that we are seeking to minimise.

Lazard’s quantitative equity team was an early advocate of a low volatility equity approach following research on strategies designed to meet investor needs for equity returns with reduced risk. The benefits of such an approach are just beginning to gain traction in the wider investment community, evidenced by an emerging group of low-risk managers and the introduction of benchmark indices from several providers. Relative to traditional market capitalisation benchmarks these strategies provide the benefit of reduced capital loss, but at the expense of underperformance within sharply rising markets. Total returns will be similar over the longer term but with a steadier and more predictable return pattern.

Increasing investor interest could be partially the result of the prevailing economic and geo-political conditions the world faces in the short and longer term. The global financial crisis has ushered in a raft of systemic changes including an era of deleveraging, the spectacular growth of the developing world and challenges to political and financial institutions at a global, regional and domestic level. Market outlook has morphed into managing under uncertainty. Under this scenario, markets tend to be highly volatile, yet directionless over the medium to long term. Traditional asset allocation models are likely to be challenged as investors look for a more dynamic approach under this regime of uncertainty. Against this backdrop, low volatility can form one part of a credible solution.

But perhaps more importantly, we believe low volatility is becoming an attractive solution because of what it provides to pension schemes, insurance firms, charities and individual investors facing a funding risk dilemma. Focusing on an investor’s ultimate return objective, as opposed to a market cap equity benchmark, removes inefficiencies and offers a significant risk/return benefit to an investor’s overall portfolio.

We think low volatility equities are a solution for those who cannot tolerate the volatility in asset prices, but need the long-term capital appreciation that equity offers.